This isn’t academic nitpicking. Check out the charts in this post and see how the United States is shooting itself in the foot by imposing some of world’s highest tax rates on capital income.

So why make a bad situation even worse?

The Tax Foundation addresses this issue in a new report on what would happen if there was more double taxation of capital gains and dividends.

A conventional static revenue estimate, which assumes away tax-induced growth changes, might suggest the federal government would collect more revenue by taxing capital gains and dividends as ordinary income. When growth effects are added to the analysis, however, the higher revenue disappears. Ending the individual income tax’s rate cap on long-term capital gains and qualified dividends would reduce capital formation, productivity, and wages to such an extent that it would be a major revenue loser for the federal budget. Few tax increases would actually cost revenue, but the capital gains (and dividend) tax is one of them.

Here are some of the details from the study.

…the desired capital stock is extremely sensitive to its expected after-tax return. The Tax Foundation model predicts that after a several year adjustment period, the capital stock would be 16.9 percent less than otherwise, work hours would be about 1.25 percent less, and GDP would be 6.3 percent lower than otherwise. Because tax collections depend on the size of the economy, these anti-growth effects would be expected to have a negative feedback on tax collections. When our model takes the smaller economy into account, it estimates that ending the rate cap on long-term capital gains and qualified dividends would actually reduce federal revenues by $122 billion.

As you can see in the chart, estimates of annual tax hikes turn into the reality of annual revenue losses once these Laffer Curve-type effects are added to the equation.

Now let’s conduct a thought experiment. Economics is an inexact science (to put it mildly), so perhaps the Tax Foundation economists are wrong. As a matter of fact, let’s assume they dramatically overstate the economic impact of double taxation.

For the sake of simplicity, let’s do a rough cut-the-baby-in-half exercise and assume that GDP only falls by about $500, which implies that there is no loss of tax revenue.

Does that mean it’s okay to increase the double taxation of dividends and capital gains?

The answer – which should be screamed from every rooftop – is no! It makes zero sense to reduce the economy’s output and make the American people poorer. Particularly when there is no upside (and I don’t think more tax revenue is an upside, but we’ll leave that issue for another day).

For more information (at least with regards to the tax treatment of capital gains), here’s a video I narrated for the Center for Freedom and Prosperity.

If the intent is to raise more tax revenue, rather than self-destructive class warfare, increasing the capital gains rate fails for two reasons:

First, a change in the capital gains rate makes existing stock holdings less attractive so [everything else equal] stock prices should go down. For example, if the current tax is 20%, stock holders effectively own 80% of returns. If the tax rate was increased to 40%, the effective ownership would drop to 60%, for a 25% drop in value. Since capital gains is based on price appreciation, that one-time drop will wipe out most of the previous capital gains tax base. For dividends, many companies will stop paying dividends, if they are only to be taxed away.

Second, increasing the tax rate increases the “hurdle rate” that must be met for new investment. For example, if an investor targets a 10% after-tax payout; at a 20% tax rate that investor’s hurdle rate is 13.3%. If the tax rate is increased to 40%, the hurdle rate on new investments becomes 16.6%. Obviously, there are far fewer investments that yield 16.6% than 13.3%, and far fewer at that rate than 10%.

And, look at what is lost if investments are not made: Of an average company’s revenues, 60% goes to net wages, 25% goes to taxes, 10% is reinvested net profit, and 5% is net profit paid out. By taxing dividends at 20%, government is attempting to keep 26% of revenues, rather than the 25%. However, if the hurdle rate cannot be achieved because of the tax on investment, the government loses 25% and workers are never employed to earn the 60% of the revenues of the company that would have existed. And we wonder where the jobs have gone??!!

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